I haven't written anything in a long time. Mostly because I've been doing my last semester of law school. Which is the best time of anyone's life. It's like your birthday between ages 5 and 10. Except that instead of once a year, it's your birthday every day. It's great. But that's over now, and I've gotta devote my energy to studying for the bar. Which, of course, means putting that off by writing about things that I find more interesting than personal jurisdiction in New York. Also, unlike personal jurisdiction in New York, I choose the things I write here, so I might actually know something about them.
Today's topic is really two parallel topics with a single theme: the ways economic policymakers have used (and abused) the idea of expectations-based policy to push different approaches to fixing the economy. Unsurprisingly, one of these approaches is much much better than the other. On the one side, we've had the expansionary austerity types. Standard economic theory is pretty clear about the effect of austerity-- contractionary fiscal policy (meaning spending cuts or tax hikes) by the government is, on net, contractionary. Of course, it doesn't have to be contractionary overall-- an economy can cut spending but still grow if the central bank counteracts that with looser fiscal policy. Which, under present conditions, is more or less unavailable in advanced economies in which, more or less across the board, interest rates are close to as low as they can go.
The idea behind expansionary austerity is that what's really holding back economies is... budget deficits. Ignoring the reality that budget problems across more or less all of Europe (Greece being a notable exception) and the US were caused by a collapse in tax revenues due to the economic crisis, expansionary austerity types decided that people and businesses aren't spending or investing because they're afraid that, someday, when the economy recovers, they'll have to pay higher taxes to service their nations' debt. The logic is as convoluted as it sounds. And just as wrong. The reality is that people aren't spending because they either don't have income (or their income comes in the form of unemployment benefits) or they're afraid of losing their source of income. And businesses aren't hiring because they aren't moving products. They're still immensely profitable (the surge in the stock market is a pretty good indicator of that, especially since P/E ratios are pretty close to historical averages, unlike those of the bubble years in the late 90's), but that's largely because big public companies both have access to overseas markets and have disproportionate power in the labor market-- workers don't have much space to demand higher wages when a big chunk of the workforce is still out of work and would gladly take the job.
But expansionary austerity, on the basis of the magic idea of "confidence" has been plenty influential on the American and especially the European right, mostly because I think people like to think of economics as a morality play where we need to repent for past sins by punishing the undeserving (read: poor people). So we get fiscal contraction in a depressed economy, with the justification that it will all pay off when "confidence" returns. So Europe tried it. Spoiler alert: confidence didn't return. Instead, they got a Depression that's been worse, for the most part, than the Great Depression for most of the continent. With no intellectual edifice for this disaster (Expansionary austerity folks loved to point to a paper by Alesina/Ardagna that seemed to say that austerity could be expansionary; it was hugely clear to anyone that actually read the paper that they didn't, you know, control for monetary policy, which made the whole exercise worse than useless. Reinhart/Rogoff 2010 was also briefly used for this purpose; I never put much stock in the causal story in that one, but everyone knows what happened to that one), hopefully expansionary austerity will finally go into the desk drawer where policymakers put the rest of their worst ideas.
On the other hand, a group of economists ranging from the Keynesian left (like Paul Krugman) to the right (Scott, Sumner, Greg Mankiw, Ken Rogoff) to the center (Ben Bernanke, Michael Woodford) has suggested that a concerted effort by the central bank to commit to a slightly higher rate of inflation (say, 4% instead of the unofficial 2% target) or a nominal GDP number, which essentially have the same effect, would induce a change in market expectations and stimulate spending. The idea is that, with inflation expectations well-anchored now, and indeed running persistently below target, people aren't sufficiently induced to spend. In particular, corporations sitting on cash (and American corporations have a LOT of cash on hand) would need to spend that cash on something or risk the value of the cash eroding, since inflation reduces the nominal buying power of cash. The trick to this is that inflation is somewhat self-fulfilling. When people expect prices to rise, they demand higher wages. When they demand higher wages, they tend to get those higher wages and can spend more of them on the same products. At the same time, savers have to move their cash into some higher-yielding use. That might mean stocks, but it frequently means investments with positive net-present value that boost employment and other productive activities. At the same time, higher wages mean that the real value of outstanding debt falls, since the same nominal debt is less of a burden for someone whose income is rising. Given that our collective debt (mostly still private debt that came out of the mortgage collapse, where people found that their homes were worth less than their mortgage debt) is still a drag on the economy, higher inflation makes paying down that debt easier and quicker.
So how is this second approach different from the first? Well, to start with, if it fails, the worst-case scenario, absent a complete bungling of policy on the part of the central bank, is that nothing happens. Under present conditions (short-term interest rates at close to 0 and unemployment persistently high), expansionary monetary policy by itself doesn't do anything (since you can't have a nominal interest rate below 0; people will just hold cash). So, if monetary stimulus doesn't stimulate, you're in the same place that you started. The idea behind unconventional monetary stimulus at this point is to move expectations so that monetary stimulus essentially becomes self-fulfilling (there's also a real element to it; it doesn't matter how much inflation people expect, if there isn't enough money circulating to get them pay raises, there won't be any pay raises, just higher unemployment). If inflation does take off, well, central banks have tools to deal with that. If it doesn't, you're in the same place you started. In fact, the people I listed have different levels of confidence in how effective inflation targeting actually will or can be. Scott Sumner is very confident. Paul Krugman isn't so confident, but his position amounts to "It might not work, but we might as well try this, along with fiscal policy." ( As a card-carrying Keynesian, Krugman has a lot more faith in fiscal policy to do the job with interest rates at zero.) In other words, it's a hope with pretty limited downside. Inflation targeting also has the added benefit of not being the exact opposite of what textbook economics says you should do when the economy suffers from insufficient demand (like, you know, contractionary fiscal policy).
Shockingly, I come down in the second camp. I have no clue how effective NGDP/inflation targeting can be, but I figure, as long as the economy is depressed, there's no reason not to try. It's a hope, but it's a hope that we might as well try. On the other hand, summoning confidence through expansionary austerity, for a lot of people, was a plan. And it was a plan that, predictably, was a very human disaster. And for that, those who pushed it should be ashamed.
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